Call: Buyer's Perspective

The Opportunity
The buyer has a “gut feeling” the land is going to increase in value sometime in the near future. His research suggests that the land will increase in value to $500,000 once the announcement is made. If he were able to buy the land for $100,000, this would be approximately a 400% return on his money!!!

Risk
The buyer also knows the risks involved with these investments. He also knows that if the mall isn’t built, the value of the land will likely remain stagnant for many years to come. He also knows it’s possible it could drop significantly, especially if the planners decide to put some other type of property there (i.e. water treatment facility). $100,000 tied up in one property would be a large risk for this investor.

Buying the Call
For the buyer, the call option represents a method to enhance their investments and limit their risk. By using the call option, the buyer could put up only 10% of the value, and still be able to enjoy the any rise in the price of the land.


The Win
If the rumor is true, and the land does increase to $500,000, he could exercise his option and buy the land for $100,000. He could then sell the land on the open market for $500,000, and enjoy his $390,000 profit ($500,000 - $100,000 (for the land) + $10,000 (for the call)).

An Added Bonus
Let’s imagine the option buyer doesn’t have the $100,000 needed to buy the land. Thus, he’s holding the opportunity to buy $500,000 worth of land for $100,000, and can’t take advantage. He could, in this case, sell the actual option itself. Remember, it is now worth $400,000 ($500,000 (price of underlying) - $100,000 (strike price)). Thus, he could sell the option for $400,000, and enjoy a $390,000 profit. Since his initial investment was only $10,000, that would be a 3900% profit!!!

The Injury
If the rumor is false, the buyer loses the $10,000 completely. He’s lost 100% of his investment!!! While this may sound bad, this is okay to the buyer because he didn’t have to pay $100,000, and doesn’t have to deal with property that isn’t going anywhere fast. However, on the other hand, land values tend to go up over time. If he’d purchased the land outright, he could still put it back on the market, and in time turn the transaction into a complete profit.

Adding Insult to Injury
Let’s imagine the buyer was right, but just a bit too early. Let’s say that after delays, tabled items, and numerous council and town hall meetings, the planning committee decides to approve the mall…1 day after the option expired!!! The value of the land jumps to $500,000. Thus, the option buyer was correct in his research, imaginative in looking for his opportunity. However, he must face the fact that, despite being absolutely correct, he’s lost 100% of his investment!! If he’d simply bought the land outright, he could have simply waited for the planning committee’s decision…be it the following week, month, or even years down the road.